Compensation, Return on Capital and Return of Capital

Compensation, Return on Capitaland Return of Capital

Richard R. [email protected]

http://www.orsinger.com

Orsinger, Nelson, Downing & Anderson, LLP

San Antonio Office:1717 Tower Life BuildingSan Antonio, Texas 78205

(210) 225-5567http://www.orsinger.com

and

Dallas Office:5950 Sherry Lane, Suite 800

Dallas, Texas 75225(214) 273-2400

http://www.ondafamilylaw.com

New Frontiers in Marital PropertyOctober 4-5, 2012

Omni Royal Orleans HotelNew Orleans, LA

© 2012Richard R. OrsingerAll Rights Reserved

Compensation, Return on Capital, and Return of Capital Chapter 1

Table of Contents

I. INTRODUCTION.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1II. COMPENSATION.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A. WAGES, SALARY AND BONUSES.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1B. DEFERRED COMPENSATION.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1C. FRINGE BENEFITS... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1D. HOW IS CURRENT COMPENSATION CHARACTERIZED?. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2E. HOW IS DEFERRED COMPENSATION CHARACTERIZED?. . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1. Defined Contribution Plans.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22. Defined Benefit Plans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

a. Taggart Time-Allocation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3b. Berry Valuation... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3c. Qualified vs. Non-Qualified Plans.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

3. Options/Restricted Stock.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4a. Cliff Vesting vs. Vesting in Tranches.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

4. Other Deferred Compensation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5a. Bonuses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5b. Delayed Payments Based on Performance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6c. Is a Berry Valuation Even Possible, at the Time of Divorce?. . . . . . . . . . . . . . . . . . . . . . . . 6d. How Would Jensen Reimbursement be Calculated?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

F. POST-DIVORCE INCOME FROM PRE-DIVORCE WORK.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71. Future Personal Earnings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72. Personal Goodwill.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83. Contingent Fee Contracts... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84. Renewal Commissions... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85. Residual Income... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96. Disability Payments.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

G. HOW IS ADVANCED COMPENSATION CHARACTERIZED?. . . . . . . . . . . . . . . . . . . . . . . . . 10H. COMPENSATION IN CONNECTION WITH SELLING THE BUSINESS. . . . . . . . . . . . . . . . . . 11

III. RETURN ON CAPITAL/RETURN OF CAPITAL.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11A. MUTATIONS OF OWNERSHIP INTEREST.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11B. CASH DIVIDENDS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11C. STOCK DIVIDENDS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11D. PARTNERSHIP DISTRIBUTIONS... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12E. SELLING AN OWNERSHIP INTEREST.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1. Character of Sales Proceeds.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122. Post-Sale Employment and Consulting Agreements.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123. Covenants Not to Compete.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

F. PARTIAL AND TOTAL LIQUIDATIONS.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121. Distributions of Profits... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122. Complete Liquidation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123. Partial Liquidation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

G. TEX. BUS. ORG. CODE § 153.208... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

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COMPENSATION, RETURN ON CAPITAL,AND RETURN OF CAPITAL

by

Richard R. OrsingerBoard Certified in Family Law& Civil Appellate Law by the

Texas Board of Legal Specialization

I. INTRODUCTION. Texas law is inconsistent inthe way it treats different kinds of compensation forservices rendered. And surprisingly, there are manyareas where the proper way to characterize compensationis uncertain. Where a spouse is both an owner and anemployee of a business, there can be difficultiesdiscerning whether money or assets received from thebusiness are compensation, or a return on investedcapital, or a return of invested capital. This can createproblems when valuing the business. If the ownershipinterest in the business is separate property, issues arisewhether distributions from the business arecompensation (i.e., community property), or return oncapital (i.e., community property), or return of capital(i.e., separate property). This paper explores some ofthese issues.

II. COMPENSATION. As used in this Article,“compensation” means earnings from employment. Oneperspective on compensation is the term “personalservice income.” Personal service income is describedin IRS Publication 570 (2011) in this way:

Income from labor or personal services includeswages, salaries, commissions, fees, per diemallowances, employee allowances and bonuses, andfringe benefits. It also includes income earned bysole proprietors and general partners fromproviding personal services in the course of theirtrade or business.

<http://www.irs.gov/publications/p570/ch02.html#en_US_2011_pub

link1000221205>. The IRS has another concept that appliesto owners of sole proprietorships and partnerships, called“earned income.” Earned income consists of “netearnings from self-employment” which is “your grossincome from your trade or business (provided yourpersonal services are a material income-producingfactor) minus allowable business deductions.”<http://www.irs.gov/publications/p560/ch01.html>.Earned income is probably synonymous with the secondsentence in the definition of personal service incomegiven above. Be that as it may, in this Article“compensation” includes both personal service income

and earned income.

Compensation can be current, deferred, or advanced. Current compensation is paid at the end of a pay-period,with no further delay. When compensation is deferred oradvanced, marital property disputes can arise. ThisArticle suggests that there are three approaches tocharacterizing compensation: (i) the inception-of-titleapproach (with or without offsetting reimbursement); (ii)the time-allocation approach; or (iii) the valuationapproach (on date of divorce). The three approachescould be called the Boden, Taggart, and the Berryapproaches, based on cases that espoused each approach.It must be noted that TEX. FAM. CODE § 3.007(c) adoptsthe time allocation Taggart approach for employee stockoptions and restricted stock. However, other deferredbenefits are not included in the statue, so the propercharacterization is a matter of common law.

A. WAGES, SALARY AND BONUSES. Currentincome for services rendered by an employee is normallypaid as wages, salary, tips, and bonuses. The employeris supposed to issue a Form W-2, setting out the incomeand the employee is supposed to report such income onLine 7 of the Form 1040 Personal Tax Return. UnderTexas law, such income earned during marriage iscommunity property.

B. DEFERRED COMPENSATION. T h e I R Sdefines “deferred compensation” as compensation that isearned in one tax year but is paid in another tax year.Under Texas marital property law, deferredcompensation is compensation for labor that is not paiduntil some time after the services are rendered. Exactlyhow long a delay is required before the compensation isdeferred is subjective. Deferred compensation could bedeferred a few months, or until the next calendar year, oruntil retirement. And deferred compensation can bedependent upon, or contingent upon, subsequent events.

C. FRINGE BENEFITS. “Fringe benefits” are a formof compensation, but most employers treat themdifferently from wages, salary, and bonuses. Some

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owner-employees cause the business to provide fringebenefits without reporting them as income for taxpurposes. Fringe benefits are addressed in the IRSpublication Executive Compensation - Fringe BenefitsAudit Techniques Guide(02-2005).<http://www.irs.gov/Businesses/Corporations/Executive-Compensation---Fringe-Benefits-Audit-Techniques-Guide-(02-200

5)>. The IRS considers fringe benefits to be taxableincome. Examples given in the Audit Techniques Guideof fringe benefits include:

• Athletic Skyboxes/Cultural Entertainment Suites• Awards/Bonuses• Club Memberships• Corporate Credit Card (unreimbursed)• Executive Dining Room• Loans (No Cost/Low Cost)• Outplacement Services• Qualified Employee Discounts• Security-Related Transportation• Spousal/Dependent Life Insurance• Transportation• Employer-Paid Parking• Transfer of Property• Employee Use of Listed Property• Relocation Expenses• Non-Commercial Air Travel• Employer-Paid vacations• Spousal or Dependent Travel• Wealth Management• Qualified Retirement Planning

D. HOW IS CURRENT COMPENSATIONCHARACTERIZED? Under Texas Family CodeSection 3.001, separate property consists of “propertyowned or claimed by the spouse before marriage,” or“acquired by the spouse during marriage by gift, devise,or descent . . . .” Under Texas Family Code Section3.002, “[c]ommunity property consists of all property,other than separate property, acquired by either spouseduring marriage. “It is well settled that a person'searnings after divorce are separate property and thereforenot subject to division.” Murray v. Murray, 276 S.W.3d138 , 147 (Tex. App.--Fort Worth 2008, no pet.).

Current income, paid daily, weekly, bi-monthly, ormonthly, is community property if received duringmarriage and separate property if received beforemarriage or after divorce. Uncertainty arises when amarriage or divorce occurs during a pay period. How doyou characterize compensation received just aftermarriage or just after divorce? The easy answer is to saythat compensation received during marriage iscommunity property, regardless of when the work was

done that gave rise to the compensation. And thatcompensation received after the divorce is separateproperty, even if the work that gave rise to thecompensation was done during marriage. However, anargument can be raised that such compensation shouldbe attributed to the period of time when the work wasdone. This is the approach taken by the Supreme Courtin Keller v. Keller, 141 S.W.2d 308 (Tex. Comm'n App.1940, opinion adopted), where the Supreme Court heldthat salary earned during marriage was communityproperty, even though it was not paid until after thedivorce. It seemed important to the Court’s decision thatthe salary was reported as income on the husband’s taxreturn during marriage, even though the salary was notactually paid until after the divorce. Id. at 311. Wouldthe result have been different if the husband had notreported the salary as income until after the divorce? TheCourt said: “Whether the salaries were drawn during thecurrent year is immaterial. When paid they were paid forthat year and were paid as salaries.” Id. at 311. So Kelleris a case of current compensation paid after divorce forwork done prior to divorce.

Where the marriage or divorce occurs during a payperiod, it raises the question of whether there should bean allocation of a paycheck or bonus between separateand community portions based on some allocationmethod, like time allocation. That policy of allocationhas been applied in the context of deferred compensation(i.e., pension plans and employee stock option andrestricted stock plans). Should the same principle beapplied to characterizing current compensation?

E. HOW IS DEFERRED COMPENSATIONCHARACTERIZED? The marital property character ofdeferred compensation differs, depending on the form ofdeferred compensation. The courts have developed threedifferent approaches to characterizing deferredcompensation: (i) the inception of title rule (withoutreimbursement); (ii) time-allocation; and (iii) thevaluation approach.

1. Defined Contribution Plans. Defined contributionplans are considered to be a form of deferredcompensation. Under existing case law, definedcontribution plans are characterized just like otherfinancial accounts. The contents of the plan account arepresumed to be community property. Tex. Fam.Code § 3.003(a). The burden to prove separate propertyis by clear and convincing evidence. Tex. Fam. Code§ 3.003(b). Where the beginning balance of the accountis known, the court subtracts the value in the account onthe date of marriage from the value of the account on thedate of divorce, and the difference is presumed to be

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community property, as having been earned orcontributed during marriage. See e.g., Iglinsky v.Iglinsky, 735 S.W.2d 536, 538 (Tex. App.--Tyler 1987,no writ). Tex. Fam. Code § 3.007(c) permits a spouse totrace commingled assets in a defined contribution planaccount, just like any other financial account. Definedcontribution plans are usually not deferred in the sensethat the contributions are delayed. They are “deferred” inthe sense that the deposits and income inside a definedcontribution plan are held in trust for the benefit of theemployee, and are not taxed until they are withdrawnfrom trust; so they are “tax deferred.” Because they arenot really deferred and they are treated like regularfinancial accounts, defined contribution plans will not befurther discussed in this Article.

2. Defined Benefit Plans. In Baw v. Baw, 949 S.W.2d764, 768 n. 3 (Tex. App.--Dallas 1997, no writ), thecourt said that “[a] ‘defined-benefit’ plan promisesemployees a monthly benefit beginning at retirement. A‘defined-benefit’ plan calculates benefits by plan-specific factors, such as years of service, age, and salary.An Interdisciplinary Analysis of the Division of PensionBenefits in Divorce and Post–Judgment PartitionActions, 37 BAYLOR L. REV. at 115.”). Defined benefitplans (i.e., pensions) typically are a right of theemployee to receive monthly payments in a set amountpaid over the retiree’s lifetime. The amount of eachpayment is the same (subject to a cost-of-livingadjustment), and is determined according to theretirement plan’s formula. The formula is usually theproduct of multiplying the number of months of totalemployment, times a set number (like 1, or 1.5, or 2,etc.), times average final compensation (as defined in theplan).

a. Taggart Time-Allocation. Under Taggart v.Taggart, 552 S.W.2d 422 (Tex. 1977), defined benefitpension plan benefits are characterized based on puretime-allocation alone. The community property interestin each pension payment is a fraction, in which thenumber of months that the pension benefit accruedduring marriage is divided by the total number of monthsthe pension benefit accrued overall. However, when thespouse will continue to accrue more pension benefit afterdivorce, it is necessary to do a Berry valuation, whichrequires a different denominator for the fraction. SeeSection II.E.2.b below.

Defined benefit pensions used to be covered by TFC§ 3.007, but that statutory provision has been repealed.

CAUTION: Many old cases, including Taggart, say thatthe denominator of the fraction is the total number of

months worked. That was true when pension benefitsaccrued over an employee’s entire period ofemployment. That is not a safe approach in moderntimes. In the current environment, many defined benefitpension plans have been capped, or suspended, and nofurther benefits accrue even when the employeecontinues to work. So a better way to describe thecomponents of the fraction is the “number of monthsduring which the benefit accrued.”

b. Berry Valuation. In Berry v. Berry, 647 S.W.2d945 (Tex. 1983), the Texas Supreme Court revisited theTaggart time-allocation formula and said that theTaggart formula could not be used to divide a pensionwhere the employee spouse would continue to accrue abenefit under the plan for work done after the divorce.The Court in Berry said that, in order to protect theemployee's separate property interest resulting frompost-divorce labors, the divorce court should divide onlythe value of the community estate's interest in theretirement benefits as of the time of divorce. Id. at 947. Under Berry, the time-allocation is through the date ofdivorce, and the numerator of the fraction is the numberof months that the retirement benefit has accrued duringmarriage while the denominator of the fraction is thetotal number of months during which benefits haveaccrued through the date of divorce. That communityfraction is multiplied times the retirement benefit thatwould be available if the employed spouse could retireon the date of divorce. The Berry court specifically saidthat it was not overruling a Taggart time-allocationformula "for determining the extent of the communityinterest in retirement benefits" for cases where the valueof the community's interest at the time of divorce wasnot an issue, like when divorce follows retirement. Id. at947. The following courts of appeals have said that theTaggart formula applies, without a Berry determinationof value, when the spouse has retired before divorce:May v. May, 716 S.W.2d 705, 710 (Tex. App.--CorpusChristi 1986, no writ); Hudson v. Hudson, 763 S.W.2d603, 605 (Tex. App.--Houston [14th Dist.] 1989, nowrit); Humble v. Humble, 805 S.W.2d 558, 561 (Tex.App.--Beaumont 1991, writ denied); Parliament v.Parliament, 860 S.W.2d 144, 145-46 (Tex. App.--SanAntonio 1993, writ denied); Albrecht v. Albrecht, 974S.W.2d 262, 263-64 (Tex. App.--San Antonio 1998, nopet.); Limbaugh v. Limbaugh, 71 S.W.3d 1, 16 (Tex.App--Waco 2002, no pet.); Stavinoha v. Stavinoha, 126S.W.3d 604, 616 (Tex. App.--Houston [14th Dist.] 2004,no pet.); Prague v. Prague, 190 S.W.3d 31, 39 (Tex.App.--Dallas 2005, pet. denied); In re Marriage ofJordan, 264 S.W.3d 850, 854 (Tex. App.--Waco 2008,no pet.).

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c. Qualified vs. Non-Qualified Plans. The distinctionbetween qualified and non-qualified retirement plansdoes not affect characterization. A retirement plan is“qualified” when it meets the requirements of theInternal Revenue Code that allows the employer todeduct contributions to the plan as an expense during theyear the contribution is made to the plan, while theemployee is not taxed on the benefit until the benefit isdistributed to the employee, sometimes years later.Additionally, the deferred payment is not subject topayroll tax. Both defined contribution plans and definedbenefit plans can be qualified. The IRS Publication AGuide to Common Qualified Plan Requirementsdiscusses the criteria that make a plan qualified. See<http://www.irs.gov/Retirement-Plans/A-Guide-to-Common-Qualified-Plan-Requirements>.

Federal law caps the maximum amount that can bedistributed to an employee under a qualified plan.Because these caps are too low to entice top executives,many companies offer benefits to high-rankingemployees through non-qualified plans. The mostdelicate part of designing a non-qualified plan is to avoidthe Economic Benefit Doctrine. The Economic BenefitDoctrine is a tax law principle saying that a benefit istaxable to the employee when the economic benefit isconferred, even if the employee does not have actual orconstructive receipt of the benefit. To avoid theEconomic Benefit Doctrine, the deferred benefit must besubject to a substantial risk of forfeiture. This has beentaken to mean that the non-qualified plan must beunfunded, and the employee’s claim must be as a generalcreditor of the company.

3. Options/Restricted Stock. Initially, Texas courtscharacterized employee stock options using the inceptionof title rule. See Boyd v. Boyd, 67 S.W.3d 398, 410 (Tex.App.--Fort Worth 2002, no pet.) (recognizing that theability to sell the options was limited); Charriere v.Charriere, 7 S.W.3d 217, 220 (Tex. App.--Dallas 1999,no pet.) (holding that the community nature of optionsgranted during marriage was not altered by the fact thatvesting of the options was contingent on continuedemployment after divorce); Kline v. Kline, 17 S.W.3d445, 446 (Tex. App.--Houston [1st Dist.] 2000, pet.denied) (holding that the stock options granted duringmarriage were community property even if not vestedbefore divorce). Nowadays, employee stock options andrestricted stock must be characterized under Tex. Fam.Code Sec. 3.007(d). Under the statute, these benefits arecharacterized on a time-allocation basis, as in Taggart,with no Berry valuation even where continued post-divorce employment is required for the options orrestricted stock to vest. Under Section 3.007(c), the

community interest in options or restricted stock isdetermined by a fraction, where the numerator is theportion of the vesting period for the benefit that accruesduring marriage, and the denominator is the entirevesting period for the benefit. Example: an unmarriedemployee receives an employee stock option on day 1.The option says that the employee must work at thecompany for a three year period before the option vests.Assume the employee marries at the start of year 2, anddivorces on the last day of year 2. Section 3.007(d) saysthat the community interest in the option is 1/3, sinceonly the middle year of the 3-year vesting period accruedduring marriage, and the first and last years accruedoutside the marriage. There is no perception, in dealingwith options and restricted stock under Section 3.007(d),that a Berry valuation should be undertaken, when theemployed spouse must continue to work after the divorcein order for the option or restricted stock to vest.Therefore stock options and restricted stock, which area form of deferred compensation, are treated differentlyfrom pensions, which are another form of deferredcompensation, in situations where the spouse owning thedeferred compensation claim will continue to work afterthe divorce. Does Section 3.007(d) violate the principlebehind Berry? Should we be attacking Section 3.007(d)as unconstitutional? Should Berry be overruled based onthe approach used in Section 3.007(d)? Would a Berryvaluation approach even be possible, or fair, given thatstock prices are volatile and no one can calculate what anoption or restricted stock will be worth in a year or two.And how would you discount for the risk of non-vesting?

a. Cliff Vesting vs. Vesting in Tranches. The properapplication of Section 3.007(d) can be affected by theway that the benefit plan is constructed. “Cliff vesting”occurs when all of the benefit vests on the final day ofthe vesting period, rather than gradually vesting overtime. Imagine two stock option plans, one with cliffvesting and one where the options vest in stages.

Hypothetical:

The Plans–Husband received two option grants onJanuary 1 of Year 1. Option Plan No. 1 gives husband anoption right to acquire 300 shares of the company’sstock. The husband must be employed at the companyfor 3 years after the grant date, in order for the options tovest, and they all vest on the last day. Option Plan No.2 gives husband an option right to acquire 300 shares ofthe company’s stock, with the first 100 shares vesting atthe end of one year, another 100 shares vesting at theend of two years, and the last 100 shares vesting at theend of three years.

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The Marriage–husband and wife marry on January 1 ofthe Year 2 of the Plans. They divorce on December 31 ofYear 2. So they are married for one year.

The Calculation

Option Plan 1 (Cliff Vesting)--Under Section 3.007(d),when the husband divorces at the end of Year 2, hisOption for 300 shares is 1/3 community property and 2/3separate property. This is because 1/3 of the vestingperiod occurred prior to marriage, 1/3 during marriage,and 1/3 after divorce. The community total under Plan 1is 100 shares.

Option Plan 2 (Staged Vesting)--Under Section 3.007(d),the first 100 shares that vest at the end of Year 1 areentirely husband’s separate property because they weregranted and vested before marriage. The second 100shares that vest at the end of Year 2 are 50% separateproperty and 50% community, because ½ of the two-year vesting period occurred during marriage. The third100 shares, which will vest one year after the divorce,are 1/3 community and 2/3 separate, because only 1/3 ofthe three-year vesting period occurred during marriage.Adding this up, at the time of divorce, of the 200 sharesreceived during marriage, 150 are husband’s separateand 50 are community property. Of the 100 shares thatmay vest in the future, 66-2/3 are husband’s separateproperty and 33-1/3 are community property. Thecommunity total under Plan 2 is 83-1/3 shares.

4. Other Deferred Compensation. The character-ization of pensions is controlled by common lawprinciples stated in the Taggart/Berry line of cases.Employee stock options and restricted stock aregoverned by Section 3.007(c). Other forms of deferredcompensation include delayed bonuses, phantom stock,performance units, stock appreciation rights, incentivepayments, etc. They do not fall under either approach.How are other forms of deferred compensation handled?Do we (i) time-allocate according to the total accrualperiod (Taggart)? Do we (ii) time allocate up to the dateof divorce and multiply times the value on the date ofdivorce (Berry)? Or do we do a third thing, which iswhat the case law did with options before Section 3.007was adopted, and that is to (iii) apply the inception oftitle rule (i.e., phantom shares, or PUs, or SARs grantedbefore marriage are 100% separate, and those that aregranted during marriage are 100% community, even ifpost-divorce employment is required for vesting). If wego the inception of title route, is there a Jensen-likereimbursement claim for enhancement in value ofseparate property benefits due to work done during

marriage, or for the enhancement of community propertybenefits due to work done after divorce? If there isreimbursement, is it measured by the amount ofenhancement or by the value of the services contributedto increase the value of the benefit? If there is someenhancement measure, what if the value of the benefitsdrops after divorce, due to stock price going down, orperformance targets not being met, etc.?

a. Bonuses. Bonuses can be deferred compensation iftheir payment is delayed. Some companies have bonusplans that say bonuses accrue over time. Most bonusesare paid after the fact for work done before the bonus isdeclared and paid. Echols v. Austron, Inc., 529 S.W.2d840, 846 (Tex. Civ. App.--Austin 1975, writ ref'd n. r.e.), held that a bonus received shortly after divorce isseparate property, because the rights of the parties werefixed at the time the divorce judgment was rendered,which was before the bonus was received. On the otherhand, in Boyd v. Boyd, 67 S.W.3d 398, 404 (Tex. App.--Fort Worth 2002, no pet.), the appellate court found thata bonus that was yet unpaid at the time of mediation wasstill community property that needed to be disclosed tothe other spouse. The Court explained:

Randall's receipt of a $60,000 bonus in 1996 wasdisclosed at mediation. He does not deny that hefailed to disclose an additional $230,000bonus—also earned during 1996—at the mediation,nor does he challenge the trial court's finding thatthe undisclosed bonus was community property. Tothe contrary, Randall testified as follows regardingthe bonus:

[Q] If someone had asked you during the time ofthat mediation what your incentive pay for that paythat you had earned for 1996 was, would you knowwhat that amount of dollars would have been?

[A] Yes, I could have. I had been paid the sixty andI knew the two thirty was coming. I just didn'tknow when, so—....[Q] You knew that at the time of mediation?

[A] Right.

[Q] And you knew the specific dollar amount at thetime of the mediation?

[A] Yeah. I was pretty clear on the dollar amount,yes.

Should the bonus be determined by the employee’s

5


marital status on date the bonus is declared or received,or should it be characterized based on the time periodover which it was earned? Also, in some instancesbonuses are paid before the work is done. See SectionII.G below.

b. Delayed Payments Based on Performance. Anumber of highly-compensated employees are givendeferred compensation that is dependent on economicperformance of the business. These include performanceunits, stock appreciation rights, and phantom stock, toname a few. Some publicly-traded corporations peg thebenefit to the increase in price of the company’s stock.Performance units might be measured against abenchmark that involves profitability, or might bemeasured against the performance of competingcorporations in the same industry. Generally they allrequire that the employee continue to be employed bythe company up to the time the benefit matures or vests.Sometimes you can say that the individual’sperformance influenced the outcome, but in someorganizations there may be too many employees to tiethe outcome to the spouse’s individual labors.

c. Is a Berry Valuation Even Possible, at the Timeof Divorce? The values of stock options and restrictedstock and phantom stock and stock appreciation rightsare derivative of the underlying value of the company’sstock. When the court wants to value non-vested benefitsnot governed by Taggart/Berry or Section 3.007, as ofthe date of divorce, who can predict the value of acompany's stock 1 year, or 2 years, or 3 years in thefuture? Do you use Black-Scholes (designed for shortterm European options traded on an open market), or thebinomial or "lattice" binomial method, or by gutting agoose and reading the entrails? The same problem existsfor performance awards that are based on meetingprofitability targets, etc.

A Berry approach would have the court value thedeferred benefit as if it were vested on the day of divorceand could be converted to cash. In Berry that approachworked because the employed spouse’s post-divorceearnings invariably caused the pension account toi n c r e a s e . H o w e v e r , u s i n g a B e r r yvaluation-on-the-day-of-divorce approach on otherdeferred compensation leads to trouble if the value of thebenefit actually declines after divorce, due to marketforces, or poor performance. In that situation, valuing thebenefit as if it could be converted to cash on the date ofdivorce would give too much value to the community’sinterest. In actuality, if the value is to be determined bystock price on the date of divorce, there should be adiscount for the time value of money, a discount for lack

of liquidity, a discount for possible reduction in value ofthe underlying stock, and a discount for the possibility offorfeiture of the benefit, applied to whatever value isproposed.

Applying a Berry approach to valuing stock options wasaddressed in Boyd v. Boyd, 67 S.W.3d 398, 411-12 (Tex. App.--Fort Worth 2002, no pet.) . The Court saidthis:

Randall also contends that the trial court shouldhave valued the stock options as of the date ofdivorce rather than giving Ginger the benefit of thevalue of the options attributable to his post-divorceemployment. Thus, Randall lodges the samecomplaint regarding the stock options as he didconcerning the retirement benefits: Ginger was notentitled to 50% of the future increases in the valueof the stock options.

Randall's company was privately held, not publiclytraded. If Randall left his employment before hewas 100% vested in his stock options, he could sellthe options to the company for the price he paid forthem. But Randall's ability to exercise his stockoptions for a profit was contingent upon hisemployer becoming a publicly traded company orbeing wholly or partially acquired by a third party.In either of these circumstances, Randall wouldhave the opportunity to sell his stock options for theprice the company received for its shares.

Randall's stock options vested at the rate of 1% peryear from 1998 through 2006, after which theybecame entirely vested. However, if Randall'scompany went public or was substantially acquiredby a third party, vesting was accelerated to 20% peryear. If there was a total sale of the company,Randall would be treated as if he were 100%vested.

The trial court determined that Randall's fair valuestock options had a contingent value at divorce of$5,628,776. This value was determined by using aformula that did not take into account Randall'spost-divorce work for his company or thecompany's future productivity. The formula wasfixed at the time of the divorce.

The contingent value of the stock options could notbe realized, however, until between 2002 and 2004,during which time a third-party corporation had theoption to acquire all of the remaining stock inRandall's company. If Randall was not employed by

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the company at that time, he would not make anymore profit on his fair value stock options becausehe would no longer be a company stockholder. Inaddition, even if his employment continued afterdivorce, Randall would not make any more profiton the stock options if the sale did not occur or ifhis company's stock did not become publicly tradedafter 2004.

To date, no Texas court has considered how todetermine the community property value of stockoptions at divorce. The cases have only addressedwhether stock options are community property. SeeKline, 17 S.W.3d at 446; Bodin, 955 S.W.2d at 381;Demler, 836 S.W.2d at 699; see also Charriere, 7S.W.3d at 220 n. 6 (holding that stock options thatcould be purchased but not sold without companyconsent during marriage were community property,even though value of options was dependent uponemployee spouse's post-divorce employment). Thefactors presented here cause us to conclude that thecontingent value of the stock options wascommunity property. The method for calculatingthis contingent value was fixed at divorce, and theminimum price for the stock options was also fixed.Randall would either be able to exercise the stockoptions in the future for their contingent value (if hewas employed and the stock sale took place or thecompany went public), or he would only be able torecover what he paid for them. Further, thecontingent value of the options was not dependenton Randall's post-divorce work for his company,even though he had to be employed to receive it.

The trial court awarded Ginger one half of thecontingent value of the stock options as her 50%share of the community estate. If Randall is nolonger employed when the stock options are sold,Ginger's contingent community property interestwill be extinguished. Any post-divorce increases ordecreases in the value of these stock options that arenot attributable to Randall's post-divorce work willnot be his separate property. Ginger will be entitledto 50% of the increases, and the contingent value ofher interest will be reduced by any decreases.Ginger will not be entitled to any post-divorceincreases in the value of these stock options that areattributable to Randall's post-divorce work for thecompany because these post-divorce increases willbe his separate property. However, the divorcedecree does not contain any language purporting togive Ginger an interest in these latter post-divorceincreases. Therefore, the trial court's division of thecontingent value of the stock options was not an

abuse of discretion. We overrule point nine.

d. How Would Jensen Reimbursement beCalculated? If a deferred compensation benefit isgranted before marriage, and the inception of title rule isapplied to make the benefit separate property, butcommunity labor is expended during marriage thatenhances the value of the benefit, is a Jensenreimbursement claim available? How do you prove acausal link between the services and the increase invalue? What if the value of services exceeds the increasein value of the deferred benefit? Is the increase in valueduring marriage a cap on a Jensen claim? What if thebenefit actually declines in value, due to a drop in stockprices, poor performance, or whatever? Is a Jensenclaim extinguished if the asset goes down in valueduring marriage.

Similar questions can be asked about a Jensen-like claimfor post divorce labor enhancing the value of acommunity property benefit. An even bigger problem isthe fact that the added value would have to bedetermined prospectively, not retrospectively as in theJensen case. How can someone determine what valuewill be added by post-divorce labors, when it isessentially impossible to value stock in advance of somefuture date.

F. POST-DIVORCE INCOME FROM PRE-DIVORCE WORK. Complications can arise withfuture income that compensates for work done beforedivorce. As noted in Murray: “It is well settled that aperson's earnings after divorce are separate property andtherefore not subject to division.” Murray v. Murray,276 S.W.3d 138 , 147 (Tex. App.--Fort Worth 2008, nopet.). That is more easily said than applied.

1. Future Personal Earnings. In Smith v. Smith, 836S.W.2d 688, 692 (Tex. App.--Houston [1 Dist.] 1992, nopet.), the appellate court rejected the valuation testimonyof an expert who valued an unincorporated business bydetermining the present value of future after-taxearnings. The court held this was a measure of thehusband personal future earning capacity, not the valueof the business. Id. at 692. The court said: “A spouse isnot entitled to a percentage of his or her spouse's futureincome. A spouse is only entitled to a division ofproperty that the community owns at the time of thedivorce. ” Id.

In Loaiza v. Loaiza, 130 S.W.3d 894 (Tex. App.--FortWorth 2004, no pet.), the court of appeals considered amajor league pitcher who signed a lucrative employmentagreement during his marriage that required him to

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perform services after divorce. Id. at 906–07. Theappellate court held that, despite the fact that theemployment agreement was signed during marriage, anddespite the fact that future payments were guaranteed ifthe player is cut from the team for lack of “sufficientskill or competitive ability,” the post-divorce paymentsconstituted compensation for future services that did notaccrue until he performed those services. They were,therefore, his separate property.

2. Personal Goodwill. In Nail v. Nail, 486 S.W.2d761, 764 (Tex.1972), the Supreme Court consideredwhether the goodwill of a sole proprietor doctor was anasset to be divided upon divorce. The Court said:

In any event, it cannot be said that the accrued goodwill in the medical practice of Dr. Nail was anearned or vested property right at the time of thedivorce or that it qualifies as property subject todivision by decree of the court. It did not possessvalue or constitute an asset separate and apart fromhis person, or from his individual ability to practicehis profession. It would be extinguished in event ofhis death, or retirement, or disablement, as well asin event of the sale of his practice or the loss of hispatients, whatever the cause. Cf. Busby v. Busby,457 S.W.2d 551 (Tex.1970), and the cases therereferred to with approval, where the husband'sexisting entitlement to future military retirementbenefits was held to constitute a vested propertyright. The crucial consideration was the vesting ofa right when the husband reached the requisitequalifications for retirement benefits; the fact thatthe benefits were subject to divestment undercertain conditions did not reduce the right to a mereexpectancy. The good will of the husband's medicalpractice here, on the other hand, may not becharacterized as an earned or vested right or onewhich fixes any benefit in any sum at any futuretime. That it would have value in the future is nomore than an expectancy wholly dependent uponthe continuation of existing circumstances.Accordingly, we hold that the good will ofpetitioner's medical practice that may have accruedat the time of the divorce was not property in theestate of the parties; and that for this reason theaward under attack was not within the authority anddiscretion vested in the trial court by Section 3.63of the Texas Family Code.

The Court went on to say that “we are not concernedwith good will as an asset incident to the sale of aprofessional practice, or that may exist in a professionalpartnership or corporation apart from the person of an

individual member . . . .” Id.

3. Contingent Fee Contracts. In Licata v. Licata, 11S.W.3d 269 (Tex. App.--Houston [14 Dist.] 1999, pet.denied), a divorcing lawyer complained about the courtawarding his wife an interest future money received asreferral fees on cases the lawyer referred out to otherlawyers. The appellate court said:

here the trial court made an implied finding thatJoseph's right to receive amounts under the referralagreements had fully vested based on the evidenceintroduced at trial. Joseph has not referred us to anyrecord evidence which contradicts or rebuts thatimplied finding. Without any clear and convincingevidence to overcome the trial court's impliedfinding regarding the vesting of the right to theincome under the referral contracts, we do not findthe trial court abused its discretion in awardingLinda a percentage of Joseph's income fromreferred cases. It is undisputed that the benefitsfrom a vested property right are communityproperty even though they may be paid afterdivorce.

Id. at 279.

In Von Hohn v. Von Hohn, 260 S.W.3d 631, 642 (Tex.App.--Tyler 2008, no pet), the appellate court found thata plaintiff’s-lawyer-husband’s right to receive moneyfrom cases that had been settled but not fundedconstituted divisible community property, because“Edward's right to receive these proceeds is contractualand the amounts to be received are fixed or readilyascertainable . . . .” Id. at 642. The appellate court foundno community interest in pending but unsettled cases,saying that “[r]evenue from these cases is no more thanan expectancy interest and any money to be receivedconstitutes future earnings to which Susan is notentitled.” Id.

4. Renewal Commissions. Insurance agents aretypically compensated based on a percentage of thepremiums the insurance company receives from theagent’s sale of insurance policies. The percentage appliesnot only to initial premiums, but also premiumsgenerated by the renewal of existing policies. InCunningham v. Cunningham, 183 S.W.2d 985 (Tex. Civ.App.--Dallas 1944, no writ), the agent’s wife claimedthat the community estate upon divorce included thehusband-agent’s right to receive a percentage of futurerenewal premiums on policies sold by the husbandduring marriage. The court of civil appeals rejected thatargument, based on two considerations: (i) the decision

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to renew would be made by customers at some time inthe future; and (ii) the husband’s agency agreement withthe insurance company provided that his right to receiverenewal commissions would terminate if the agencyrelationship terminated. Because the right to receivecommissions was contingent on the customers renewingtheir policies and the husband's continued employmentby the agency, the renewal commissions were not avested right, but instead were a mere expectancy. Id. at986. Under Texas law at the time, only vested rightscould be divided on divorce–law that changed in Cearleyv. Cearley, 544 S.W.2d 661 (Tex. 1976).

The later case of Vibrock v. Vibrock, 549 S.W.2d 775(Tex. Civ. App.–Fort Worth), writ ref’d n.r.e., 561S.W.2d 776 (Tex. 1977), involved another divorcinginsurance agent. The husband’s agreement with theinsurance company provided:

On provisions of Vibrock's contracts with FidelityUnion Life Insurance Company: After the portionthereof which set forth the Agent's entitlement(Vibrock's) on “first year commissions onpremiums”; the same for “second yearcommissions”; and the same for “subsequent years”was a provision as follows: “Agent agrees that forso long as this contract shall remain in force andeffect, he will not enter the service of any otherinsurance company . . ..”

Further contractual provisions: “No renewalcommission shall be payable on the businessproduced during any contract year not fullycompleted by the Agent while in the service of theCompany. . . . Renewal commissions are paid inrecognition of continuous full time service and ascompensation for services rendered in keeping thebusiness in force.” Further, “If for any reason thiscontract should be terminated within three (3)years, no renewal commissions shall be paid to theAgent thereafter.”

Id. at 778. The court of civil appeals concluded:

We are of the opinion that by the contract ofVibrock with Fidelity Union Life InsuranceCompany the liability of the latter was madecontingent upon conditions precedent as applied toVibrock's entitlement to any renewal premiums,both before and after date of the parties' divorce;that by contract not only would Vibrock be obligedto continue this contract itself in force, but also toservice the business he had placed on the books.The contract provided that his entitlement was (or

would be) “. . . in recognition of continuous fulltime service and as compensation for services (tobe) rendered in keeping business in force.”(Emphasis supplied.)

For the trial court to award plaintiff the interest shesought would be to award her a personal judgmentwhich would not be referable to property inexistence upon divorce.

Id. at 778.

What is very, very interesting is that the Supreme Courtdenied review of the court of civil appeals’ decision inVibrock, but they said this in a per curiam opinion:

PER CURIAM.

The application for writ of error is refused, noreversible error.

Wendell Vibrock sold insurance policies forFidelity Union during his marriage to LyndaVibrock. Under his employment contract withFidelity Union, Wendell Vibrock was to receiverenewal commissions when these policies wererenewed. Lynda Vibrock sued Wendell Vibrockclaiming an interest in certain of these renewalcommissions. She asserts these commissions arecommunity property which were not considered inthe partition of the parties' property upon divorce.The court of civil appeals reversed the summaryjudgment rendered by the trial court in favor ofWendell Vibrock and remanded the cause for trial.549 S.W.2d 775.

The disposition of this case by this court indicatesneither approval nor disapproval of the languagecontained in the opinion of the court of civilappeals which suggests that these renewalcommissions are not community property. SeeCearley v. Cearley, 544 S.W.2d 661 (Tex.1976).

Vibrock v. Vibrock, 561 S.W.2d 776, 776-77 (Tex.1977).

5. Residual Income. Residual income is income thatis to be received in the future based on work done in thepast. The issue of residual income was addressed inMurray v. Murray, 276 S.W.3d 138 (Tex. App.–FortWorth 2009, pet. denied). This post-divorce caseinvolved a husband who worked as an independentbroker for a multi-level marketing company thatprovided discount health services. Id. at 141. His job

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involved getting customers to sign up for monthlymemberships and to enlist brokers to sign up members,and he received a percentage of the membership feesgenerated by himself and by brokers he originallyenlisted. Id. In the divorce decree, the wife was awarded60% of residual income based on business generatedprior to the date of divorce and upon the book ofbusiness as of the date of divorce. Id. at 143. On appealfrom a post-divorce law suit, the appellate court said thatthe former wife was entitled to continue to receive 60%of the money that comes in from the members andbrokers that were in place, but not from members orbrokers added after the date of divorce. Id. The membersand brokers are called the “downline.” The Court said:“Whereas, the monthly income from the downline inexistence at the time of divorce is already earned, theincome resulting from new members and brokers beingadded after divorce is not.” Id. at 147. Note that theCourt said the income from the existing downline was“already earned,” even though the future membershipfees were not yet due or received. Importantly, theappellate court was not influenced by the fact that theformer husband had to recruit one new member or brokereach month in order to receive the income from thedownline. Even though the future income had not yetbeen received, it had already been earned. Id. at 147.The former husband did get to keep 100% of incomefrom members or brokers added after divorce. The Courtsaid: “Because the addition of new members and brokersis not a guarantee, the growth in income resulting fromnew member and brokers is merely an expectancy.” Id.at 148.

6. Disability Payments. The case of Simmons v.Simmons, 568 S.W.2d 169, 170 (Tex. Civ. App.–Dallas1978, pet. dism'd), held that long-term monthly disabilitybenefits provided by an employer and payable to aformer husband after divorce are community property,because the right to the payments was part of thehusband's compensation for services during marriage.That law has been overturned by the adoption of TexasFamily Code Section 3.008(b), which characterizesdisability payments based on whether the lost incomebeing replaced occurred during marriage or not.However, the original argument remains in otherdomains, that contractual rights arising fromemployment during marriage are community property.This is sort of an inception of title approach.

G. HOW IS ADVANCED COMPENSATIONCHARACTERIZED? Characterization problems canarise when compensation is paid in advance for futureservices. Sometimes an employee is paid a “signingbonus” for agreeing to come to work. This happens often

with professional athletes. If the signing bonus isreceived during marriage, but is contingent uponemployment continues after the divorce, is the signingbonus entirely community property or is it to be prorated between community and separate according to thenumber of months of employment during marriage vs.the number of months after divorce? In Loaiza v. Loaiza,130 S.W.3d 894 (Tex. App.--Fort Worth 2004, no pet.),the spouse-athlete received such a signing bonus abouta year before divorce. Unfortunately for us, nocontention was raised that the signing bonus should beprorated.

An article from the Journal of the American Academy ofMatrimonial Lawyers presents this analysis of the issue:

The argument that a signing bonus actuallyconstitutes future income is based on equitableconsiderations. The court then must be persuaded torecognize the realities of the NFL salary cap. Inother words, the argument is one of substance overform.

First, it must be conceded that a court is likely toconsider a signing bonus that has already beenreceived by the parties a vested marital propertyright. A Texas court has defined the word “vested”as “a fixed right of present or future enjoyment.”[FN23] Therefore, although the court is going toview the signing bonus as a vested asset, it is up tothe advocate to show the court that this should becharacterized as future income. In the case of aretirement benefit, courts often look to see if thebenefit was earned during the course of themarriage to determine if it is divisible. [FN24] Thecourt must be shown that the signing bonus was notearned during the marriage. Although the signingbonus actually may be received during themarriage, it may be in exchange for the athleteagreeing to take less salary in the future. The NFL'sown salary cap policy takes this into considerationand distributes the signing bonus salary cap impactover the lifetime of the contract.

This kind of reasoning might appeal to a court. Askthe court to consider applying the effect of thesigning bonus the same way it is calculated by theNFL. If this argument were successful, only aportion of the signing bonus would be divisiblemarital property. The remainder of the signingbonus would be allocated over the remaining yearsof the contract as future income, just as the basesalary is allocated.

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Acceptance of a signing bonus in return foraccepting a lower base salary during the early yearsof the contract can be compared to a corporationoffering employees a lump sum payment to retireearly. Often a company will offer a highlycompensated employee some type of subsidy toinduce the employee to take an earlier retirement.This is not a mere altruistic gesture by thecompany, but an attempt to induce a highlycompensated employee to retire early, so a lesscostly employee can replace him or the position canbe eliminated altogether.

Similarly, NFL teams do not pay players largesigning bonuses because they want to reward theplayer for signing the contract. They pay a signingbonus to maneuver around the NFL salary cap andfree up more money to sign other skilled players,thereby making the team more competitive. Theplayer has to forgo the right to earn more moneyunder the base salary because he accepted thesigning bonus. Texas case law supports the positionthat a payment to induce an employee to retire earlyis not a benefit which is earned or accrued duringthe employee's tenure, but is merely an incentive toget the employee to retire early, thereby benefittingthe company financially. [FN25] The court may bepersuaded to view a signing bonus the same way.The player is giving something up in the future toget the bonus. The court needs to understand thatthe signing bonus was not to reward past or currentservices, but actually to compensate the athlete forfuture services.

The main obstacle in successfully arguing that asigning bonus is not marital property is the fact thatthe marital estate has already received payment.Even if a signing bonus is subject to forfeiture, acourt is likely to still view the bonus as a vestedproperty right. A Texas court has stated “thepossibility that a property right may be subject tototal or partial forfeiture, does not destroy itscharacter as a vested property right for the purposesof division on divorce.”

Katherine A. Kinser & R. Scott Downing, Family LawIssues That Impact the Professional Athlete, 15 J. Am.Acad. Matrim. Law. 337, 345-47 (1998). The authorsnote possible complications if the bonus can be forfeitedat a later time. Id. at 347.

H. COMPENSATION IN CONNECTION WITHSELLING THE BUSINESS. In some business sales,the buyer pays not only a purchase price, but also agrees

to pay the selling owner to continue to work for, orconsult with, the business. If such payments exceed thevalue of services to be rendered, they might be disguisedsales proceeds to the extent of the excess. Covenants notto compete are discussed in Section III.E.3 below.

III. RETURN ON CAPITAL/RETURN OFCAPITAL.

A. MUTATIONS OF OWNERSHIP INTEREST.Shares of stock acquired through stock splits have thesame character as the original stock. Harris v. Harris,765 S.W.2d 798, 803 (Tex. App.--Houston [14th Dist.]1989, writ denied); Horlock v. Horlock, 533 S.W.2d 52(Tex. Civ. App.--Houston [14th Dist.] 1975, writdism'd).

In Carter v. Carter, 736 S.W.2d 775 (Tex.App.--Houston [14th Dist.] 1987, no writ), the partiesmarried on December 7, 1974. Husband testified that in1970 he received 159 shares of stock in MPI, afamily-owned business, as a gift from his father. Hecorroborated this testimony by showing dividendsreflected on his 1974 tax returns, coupled with histestimony that MPI declared dividends at the end of theyear and paid them in the following year. In 1976, MPIwas acquired by Stauffer Chemical Company, andhusband received 4,645 shares of Stauffer in exchangefor his MPI stock. In 1979, Stauffer had a 2-for-1 split,raising husband's shares to 9,290 in number. In 1981,husband sold 1,156 plus 1,000 shares of Stauffer, andexpended the proceeds. Husband acquired 166 shares ofStauffer stock as a Christmas gift from his father in 1981which he later sold, and participated in six short sales in1982 and 1983. The trial and appellate courts held thatthe stock was proven to be husband's separate property.

In Horlock v. Horlock, 533 S.W.2d 52, 59 (Tex. Civ.App.--Houston [14th Dist.] 1975, writ dism'd), husbandowned stock in a corporation prior to marriage. Duringmarriage, that corporation merged with two othercorporations to create yet another corporation. The courtfound that the new stock was husband's separateproperty--this despite the fact that he and the otherowners of the old corporation put $200,000 into themerger.

B. CASH DIVIDENDS. Cash dividends fromcorporate stock are community property. See Hilliard v.Hilliard, 725 S.W.2d 722, 723 (Tex. App.--Dallas 1985,no writ); Bakken v. Bakken, 503 S.W.2d 315, 317 (Tex.Civ. App.--Dallas 1973, no writ).

C. STOCK DIVIDENDS. Stock dividends deriving

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from separate property stock are separate property. SeeDuncan v. U.S., 247 F.2d 845, 855 (5th Cir. 1957). Stockdividends arising from community property stock arecommunity.

D. PARTNERSHIP DISTRIBUTIONS. Partnershipprofits distributed to a partner during marriage arecommunity property, regardless of whether thepartnership interest is separate or community property. Harris v. Harris, 765 S.W.2d 798, 804 (Tex.App.--Houston [14th Dist.] 1989, writ denied); Marshallv. Marshall, 735 S.W.2d 587, 594 (Tex. App.--Dallas1987, writ ref'd n.r.e.). What about distributions ofcapital? See Section III.G.b below.

E. SELLING AN OWNERSHIP INTEREST.

1. Character of Sales Proceeds. The proceeds fromselling a business have the same character as theownership interest. This is an application of the law ofmutations.

2. Post-Sale Employment and ConsultingAgreements. It is not uncommon, in the purchase of abusiness, for the buyer and seller to agree for the sellerto remain employed by the business for a period of timeafter the purchase/sale. This facilitates the transfer ofgoodwill, and makes for a smoother transition to newownership with customers, suppliers, and employees.Sometimes the seller agree to a consulting agreement asan alternative to an employment agreement. Becausemoney paid to buy a business must be capitalized overtime, whereas compensation paid to an employee orconsultant is deductible to the business as an expense,when paid, sellers have a tax motive to move part of thepurchase price into a compensation agreement. In anysale of a closely-held business, the terms of the sale andany related payments or agreements should bescrutinized to see if purchase price is being disguised ascompensation for future employment.

3. Covenants Not to Compete. The right to competeafter divorce is a separate property right. See Ulmer v.Ulmer, 717 S.W.2d 665, 667 (Tex. App.--Texarkana1986, no writ), which held:

An individual's ability to practice his professiondoes not qualify as property subject to division bydecree of the court. Nail v. Nail, 486 S.W.2d 761(Tex.1972). Thus, the trial court further erred inenjoining Rufus Ulmer from engaging in his chosenprofession as part of the property division.

A covenant not to compete signed during marriage,

being a contract right arising during marriage, andpayments received under the agreement could becharacterized as 100% community. On the other hand, anargument can be made that the payments representforegone wages, and that foregone wages after divorceare separate property.

Another potential concern can arise with a covenant notto compete that extends past the date of divorce. Whena business is sold, they buyer wants to get the seller”scovenant not to compete, since it protects the buyer’sinvestment in the business, assuring the buyer that theseller will not try to lure away suppliers, customers, oremployees. Some have argued that the covenant not tocompete represents the embodiment of the seller’spersonal goodwill, and as such all payments attributableto the covenant not to compete are separate propertyunder Nail v. Nail, neither received before or afterdivorce.

A similar issue arises when a deferred compensationbenefit, to be paid after retirement, is conditioned uponthe retiring employee not competing against thecompany. Some have argued that, since the covenant notto compete would prohibit post-divorce employment, thedeferred benefit is not entirely attributable to pre-retirement employment, but is also attributable to post-retirement foregone employment, and thus has a separateproperty component.

F. PARTIAL AND TOTAL LIQUIDATIONS.Controversy exists about the extent to whichdistributions made from separate property entities to amarried spouse are separate or community property.

1. Distributions of Profits. All would probably agreethat distributions of profits to a married owner arecommunity property, absent a partition and exchangeagreement or a spousal income agreement. The troublestarts when the distributions might be distributions ofcapital and not profits.

Partnership profits distributed to a married partner arecommunity property, regardless of whether the spouse'spartnership interest is separate or community property.Harris v. Harris, 765 S.W.2d 798, 804 (Tex.App.–Houston [14th Dist.] 1989, writ denied); Marshallv. Marshall, 735 S.W.2d 587, 594 (Tex. App.–Dallas1987, writ ref'd n.r.e.).

2. Complete Liquidation. In Fuhrman v. Fuhrman,302 S.W.2d 205, 212 (Tex. Civ. App.–El Paso 1957,writ dism'd), the court held that stock issued to a marriedshareholder upon dissolution of the holding corporation

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was received by the spouse as separate property.However, the character of distributions in liquidation ofa corporation was questioned in Legrand-Brock v. Brock,2005 WL 2578944, *2 (Tex. App.–Waco 2005, no pet.)(memorandum opinion) ("Brock I"), where a dividedcourt suggested that payments in complete liquidation ofa corporation might be community property to the extentthat the distributions represent retained earnings andprofits. In his dissent, Chief Justice Grey cited threecases indicating that proceeds from the liquidation of anownership interest in a business have the same characteras the ownership interest. The view of the Waco majoritywas rejected on appeal after remand by the BeaumontCourt of Appeals in Legrand-Brock v. Brock, 246S.W.3d 318 (Tex. App.–Beaumont 2008, pet. denied)("Brock II"), which held that all distributions by acorporation in liquidation of separate property shareswere received by the spouse as separate property.

3. Partial Liquidation. A controversy surroundspartial distributions from a separate property business, asto whether the are, separate property.

In Legrand-Brock v. Brock, 246 S.W.3d 318 (Tex.App.--Beaumont 2008, pet. denied) ("Brock II"), thecourt said:

A liquidating distribution includes a transfer ofmoney by a corporation to its shareholders inliquidation of all or a portion of its assets. SeeBLACK LAW'S DICTIONARY 508 (8th ed. 2004)(A "liquidating distribution" is "[a] distribution oftrade or business assets by a dissolving corporationor partnership."); see also TEX. BUS. CORP. ACT.ANN. art. 1.02(A)(13)(c) (Vernon Supp. 2007) ("'Distribution' means a transfer of money ... by acorporation to its shareholders ... in liquidation ofall or a portion of its assets.").

Brock II, at 323. The Brock II court also cited the U.S.Supreme Court in Hellmich v. Hellman, 276 U.S. 233,235, 48 S.Ct. 244, 72 L.Ed. 544 (1928), a tax case:

A distribution in liquidation of the assets andbusiness of a corporation, which is a return to thestockholder of the value of his stock upon asurrender of his interest in the corporation, isdistinguishable from a dividend paid by a goingcorporation out of current earnings or accumulatedsurplus when declared by the directors in theirdiscretion, which is in the nature of a recurrentreturn upon the stock.

Brock II, 246 S.W.3d at 324.

From an accounting or financial standpoint, corporatedistributions are treated as coming first out of currentearnings, then out of retained earnings, and finally out ofcapital. For federal income tax purposes, everydistribution of a corporation to its shareholders isdeemed to be made out of earnings and profits, to theextent there are any. See Treas. Reg. § 1.316-2(a). Thedistribution is deemed to come from current earningsfirst, and then from accumulated earnings from prioryears. Id. After current and retained earnings areexhausted, what is left, by process of elimination mustbe a distribution of capital.

Marshall v. Marshall, 735 S.W.2d 587 (Tex.App.–Dallas 1987, writ ref'd n.r.e.), is frequently cited insupport of the view that all distributions from apartnership during marriage are community property. InMarshall, the husband owned an interest in a partnershipat the time of marriage. The partnership owned mineralleases that were acquired prior to husband's marriage.The court of appeals held that the mineral interests werenot separate property, because they belonged to thepartnership and had no marital property character. Thecourt rejected the idea that the husband retained anownership interest in his capital contribution, or thatpartnership distributions were a mutation of his capitalcontribution. Id. at 594. The court also rejected the ideathat the partnership's production of oil and gas wassubject to characterization as either separate orcommunity property. Id. at 594-95. Under thepartnership agreement, it was agreed that all distributionsto the husband in excess of his salary "shall be chargedagainst any such distributee's share of the profits of thebusiness." Id. at 595. On its books, the partnershipallocated husband's draws that were in excess of theother partner's draws to husband's salary, and on thepartnership tax returns the excess draws were reported as"guaranteed payments for partners." Id. at 594. Thehusband reported the distributions as ordinary income onhis personal tax return. Id. The court noted that "allmonies disbursed by the partnership were made fromcurrent income." Id. at 595. The court concluded:

The withdrawals nevertheless were distributions ofpartnership income or profits and, thus, community.We hold that all distributions by the partnership toWoody during the course of the second marriagewere community property.

Id. at 595. Marshall clearly states that distributions ofcurrent income or profits are community property.However, the opinion does not expressly say that alldistributions from a partnership are community property.Marshall establishes that separate property capital, once

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contributed to the partnership, loses its character asseparate property, so that distributions cannot bemutations of the separate property contribution. Thesignificance of Marshall to a great degree depends onwhether you read some of the statements in the Court'sOpinion as broad principles of law, or whether you readthem as conclusions drawn from the facts in theparticular case (in particular, the language of thepartnership agreement and the fact that all distributionswere from current income).

In Lifshutz v. Lifshutz, 199 S.W.2d 9, 27 (Tex. App.–SanAntonio 2006, no pet.) ("Lifshutz II"), a subsidiarycorporation was transferred directly from a separateproperty family partnership to a separate property familycorporation in a tax-free business recapitalization. Id. at24-28. The trial court found this to be a "non-liquidatingcommunity distribution" from the partnership, and heldthe stock of the subsidiary to be community property ofthe husband. Id. at 24. After an extensive analysis of thefacts and citation to Marshall, a 2-to-1 majority of thecourt of appeals wrote:

Accordingly, since partnership property does notretain a separate character, distributions from thepartnership are considered community property,regardless of whether the distribution is of incomeor of an asset.

The court recognized that a Louisiana appellate courthad "drawn a distinction between distributions of incomeand distributions of a capital asset," but commented theLouisiana court did not analyze the effect of the entitytheory of partnerships and further noted that in thepresent case, "the accumulated profits of [thepartnership] exceeded the aggregate distributions, whichincluded the [subsidiary] stock distribution." Id. at 27 n.4.

G. TEX. BUS. ORG. CODE § 153.208. It is clear thatthe Texas Legislature believes that partial distributionsfrom a limited partnership can be a return of capital,because Section 153.208 of the Business OrganizationCode specifically covers them. The statute says:

§ 153.208. Sharing of Distributions

(a) A distribution of cash or another asset of alimited partnership shall be made to a partner in themanner provided by a written partnershipagreement.

(b) If a written partnership agreement does notprovide otherwise, a distribution that is a return of

capital shall be made on the basis of the agreedvalue, as stated in the partnership records requiredto be maintained under Section 153.551(a), of thecontribution made by each partner to the extent thatthe contribution has not been returned. Adistribution that is not a return of capital shall bemade in proportion to the allocation of profits asdetermined under Section 153.206.

(c) Unless otherwise defined by a writtenpartnership agreement, in this section, "return ofcapital" means a distribution to a partner to theextent that the partner's capital account,immediately after the distribution, is less than theamount of that partner's contribution to thepartnership as reduced by a prior distribution thatwas a return of capital.

Chapter 153 applies to limited partnerships, notcorporations, general partnerships, or limited liabilitycompanies.

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Documents

Compensation, Return on Capital and Return of Capital